Liquidity in the Foreign Exchange Market: Measurement, Commonality, and Risk Premiums

69 Pages Posted: 14 Aug 2009 Last revised: 13 Oct 2013

See all articles by Loriano Mancini

Loriano Mancini

USI Lugano - Institute of Finance; Swiss Finance Institute

Angelo Ranaldo

University of St. Gallen; University of St. Gallen - School of Finance

Jan Wrampelmeyer

Vrije Universiteit Amsterdam, School of Business and Economics; Tinbergen Institute

Date Written: June 8, 2012

Abstract

Using a novel and comprehensive dataset, we provide the first systematic study of liquidity in the foreign exchange (FX) market. Contrary to common perceptions, we find significant variation in liquidity across exchange rates, substantial costs due to FX illiquidity, and strong commonality in the liquidities of different currencies. We analyze the impact of liquidity risk on the carry trade, which is a popular trading strategy that borrows in low interest rate currencies and invests in high interest rate currencies. We find that low (high) interest rate currencies tend to offer insurance against (exposure to) liquidity risk. A liquidity risk factor has a strong impact on daily carry trade returns from January 2007 to December 2009, suggesting that liquidity risk is priced in currency returns. Finally, we provide evidence that liquidity spirals may trigger these findings.

Keywords: Foreign Exchange Market, Liquidity, Commonality in Liquidity, Liquidity Spiral, Liquidity Risk Premium, Carry Trade

JEL Classification: F31, G01, G12, G15

Suggested Citation

Mancini, Loriano and Ranaldo, Angelo and Wrampelmeyer, Jan, Liquidity in the Foreign Exchange Market: Measurement, Commonality, and Risk Premiums (June 8, 2012). Journal of Finance, 2013, Vol. 68, No. 5, pp. 1805-1841 . Available at SSRN: https://ssrn.com/abstract=1447869 or http://dx.doi.org/10.2139/ssrn.1447869

Loriano Mancini

USI Lugano - Institute of Finance ( email )

Via Giuseppe Buffi 6
6904 Lugano, CH-6904
Switzerland
+41 (0)91 912 46 47 (Fax)

HOME PAGE: http://www.people.usi.ch/mancil/

Swiss Finance Institute ( email )

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

Angelo Ranaldo

University of St. Gallen ( email )

Swiss Institute of Banking and Finance s/bf-HSG
Unterer Graben 21
St. Gallen, 9000
Switzerland
+41712247010 (Phone)

HOME PAGE: http://www.sbf.unisg.ch/Lehrstuehle/Lehrstuhl_Ranaldo/Homepage_Ranaldo.aspx

University of St. Gallen - School of Finance ( email )

Unterer Graben 21
St.Gallen, CH-9000
Switzerland

Jan Wrampelmeyer (Contact Author)

Vrije Universiteit Amsterdam, School of Business and Economics ( email )

De Boelelaan 1105
Amsterdam, 1081HV
Netherlands

Tinbergen Institute ( email )

Burg. Oudlaan 50
Rotterdam, 3062 PA
Netherlands

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